“We at the IMF see hot spots in the U.S. shadow financial system”

The Corner: The IMF has been surprisingly hard with the U.S. The fact that the financial system is solid is taken for granted, but you have alerted about the abundance of debt and the shadow financial system (non-regulated financial institutions).

Answer. The attitude of the IMF is that Europe must end the banks cleaning up process and the United States must deal with “shadow banking” (hedge funds and private equity). America’s shadow financial system is, in terms of its magnitude, twice the size of the banking system.

In Europe the relationship is exactly the opposite. And we have detected ‘hot spots’ in the shadow financial system, where debt is growing very quickly and investors are underestimating the risk when purchasing certain financial products. What we say is: “Careful, because we have already heard that song.”

There are enough ‘hot spots’ that we are suggesting the U.S. supervisor to reinforce its surveillance both at a micro and a macro levels to avoid those weaknesses to grow and become serious, and that they end up forcing the Federal Reserve to reconsider its exit strategy. If that were the case, the Fed might have to anticipate and accelerate the rise in official interest rates in order to fight the possible risks on financial stability derived from shadow banking. That would not be the best for the economic recovery in America nor in the world. Therefore, it is essential that the American financial authorities do their job.

TC: Do the Dodd-Frank Act, the Volcker rule and other similar measures have had the expansion of the shadow financial system as an unexpected consequence?

No. contrary to what is believed shadow banking has not expanded much in the last years compared to the banking system. It was already two times bigger before the crisis. It is possible that as banking regulation is enforced, there will be a greater migration of the risk to shadow banking.

But it is also true that regulations of shadow financial system are being created to control those aspects that may lead to systemic risk. These regulations are less advanced than banking ones, which in fact are being implemented. That’s where the Financial Stability Oversight Council is necessary to set the tone in terms of financial stability, and in my opinion it should act with the fullest force as possible to prevent the risks that are perceived as more dangerous.

Prevention is always more important than cures. And actions such as identifying which non-banking financial institutions are systemic to submit them to special surveillance, or make strong recommendations to supervisors are very important to avoid bigger problems in the future.

TC: You are proposing a financial system for Europe that is very different from the current one, especially when it comes to companies’ financing: a system that relies less on banks and more on the market. Do you want banks to have less influence on the European financial system?

A: What we say is that in Europe the credit is not flowing to the SMEs, which are the main factor of job creation in Spain and in other countries. Credit needs to get to companies. It may be coming from banks or not. But since SMEs currently depend mostly on banks, it is important that they are solid to give credit.

However, in the medium and long term, we should develop markets and non-bank credit sources in Europe. That can be done with methods that have been taken in Spain to promote SMEs financing. I mean, for example, national minibonds markets – Italy has done so too, and in France they have something similar-. All these steps are in the right direction, but there is something that would be very important to promote non-banking credit sources in Europe: to promote asset securitization.

These processes must avoid the mistakes of the past in the United States motly- because in Europe securitizations have been much healthier – and receive a more appropriate regulatory treatment, , e.g. solvency 2, so insurance companies can support credit to small businesses. All of this, over time, can bring more sources of financing for companies. Having a diversified portfolio is good, also when it comes to financing.

TC: In the U.S., the most that can happen with stress tests is that Citibank is not allowed to increase dividend pay and launches a share repurchase plan, or that Santander’s U.S. branch does it. But in Europe we have the precedent of 2011, when stress tests did not work. What surprises can we expect in Europe? That a bank gets its dividend cut? Or that we may need to recapitalize a bank with public money?

A: By definition, surprises are unexpected, so we cannot foresee them, or preview their dimensions. But it is also true that banks’ asset quality review and stress tests are carried out on a rigorous basis, and covering a larger number of banks, much more than what has been done in the past.

The exercise is much more rigorous and credible, and is being done under the strictest guidelines. If there are surprises, we will have to see where they come from. If they come from the first part of the exercise, which examines the quality of the assets, we must solve them immediately. If they are derived from the second part, which is the stress test, we’ll see how much time we give entities to solve those problems.

First the private sector would have to cover these capital deficiencies – via benefits, capital increases – or, if that formula is not feasible, with public funds. That can happen in some countries. And if they have a high public debt and could not accept it, there are also European mechanisms to help those countries, although as a last resort.

TC: Does the IMF find interesting the ‘discretionary’ strategy of the Federal Reserve in the stress tests, analyzing some aspects, one bank at a time, and scrutinizing big banks more thoroughly?

A: Americans are not doing anything unusual, nor are doing the Europeans. Each one is making sure through stress tests that the level of the soundness of its banks is adequate. In the United States they did so by analyzing 30 major banks. In Europe the banking sector is greater, and is much more fragmented, which involves analyzing 130 banks.